Lessons from Lehman, the global financial crisis

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Market veterans cite a variety of lessons to be gleaned from the global financial crisis. But they argue that for the most part those lessons either weren't learned or, if learned, are being applied less frequently as a low-yield market environment pushes investors further out on the risk curve.

Laurence B. Siegel, research director of the CFA Institute's research foundation, Charlottesville, Va., believes one big lesson investors should have learned from the global financial crisis is that “diversifying among many kinds of equities is about as good as not diversifying at all.”

True diversification requires allocations to fixed income and other non-equity risk factors, he said.

Alternative investments, meanwhile, “become conventional investments in a crisis” — without the liquidity — and then become alternative investments again post-crisis, in the sense that, more often than not, they don't go up as fast as conventional investments, Mr. Siegel said.

“Keep it simple” should have been the rallying cry of the past five years, said Mr. Siegel, adding “I have absolutely no reason to think that institutional investors have learned from the crisis.”

Vineer Bhansali, a managing director and portfolio manager at the Newport Beach, Calif., headquarters of
Pacific Investment Management Co., said the need to consider tail-risk hedging was a lesson that emerged from the global financial crisis, but one that faded in subsequent years as confidence that markets would behave more predictably rebounded.

As might be expected, a “huge surge of interest” inspired by the crisis led a number of institutional clients to buy tail hedges after the event, but as market volatility subsided, many chose to discontinue those programs as too expensive, he said.

Clients who stuck with their tail-risk programs “benefited substantially,” because those hedges helped them maintain larger allocations to risky assets, which delivered solid returns in recent years, he argued.

Five years later, tail-risk hedging is part of the vernacular, but as markets have stabilized, “cyclical” interest in downside protection has given way in many cases to “return chasing” and growing interest in alternative strategies, Mr. Bhansali said.

Still, the success of monetary authorities and other economic regulators in tamping one risk only raises the specter of risk emerging elsewhere, and the next challenge facing investors will be the “deleveraging risk” from the inevitable withdrawal of the huge liquidity central bankers have used to buoy markets in recent years, he said.

Asked if institutional investors have positioned themselves for that next bout of volatility, Mr. Bhansali said, “I hope so, but I don't think they have.” Investors continue to count on diversification to provide adequate protection, but it's hard to see those strategies proving “particularly robust,” he said.

Mark Kritzman, CEO of Windham Capital Management, Boston, said investors can't predict what the trigger will be for the next broad capital markets selloff, but new measures of volatility and “turbulence” — which aim to predict when correlations between asset classes are likely to be high — can help minimize damage to their portfolios.

There's no way anyone could have forecast “someone in Tunisia setting himself on fire and (sparking) years of revolution or a tsunami in Japan,” he said.

What investors can do is determine “when markets are particularly fragile,” based on new measures of risk, such as Windham's absorption ratio, which signals fragility when a small number of risk factors can explain the variability of returns for a large number of asset classes.

Such a signal doesn't amount to a forecast that markets are going to tumble. Rather, it can be read as an indication that negative news — random or not — could have a much bigger impact than it would have when the absorption ratio shows a much larger number of risk factors needed to explain the variability of returns across that same number of asset classes.

Investors who, on average, choose to become more defensive when markets are fragile and more aggressive when the absorption ratio shows markets as resilient can achieve a more stable risk profile and better returns per unit of risk taken, Mr. Kritzman argued.

Robert Arnott, chairman of
Research Affiliates LLC, Newport Beach, Calif., takes the other side of the debate when it comes to the industry's ability to successfully model risk, while seeing investors' growing focus on risk as a double-edged sword.

The fact that
Lehman Brothers Holdings Inc. had “lots of Ph.D. quants” and hedge fund Long-Term Capital Management LP had Nobel Prize winners and both firms blew up spectacularly suggests the dangers of overreliance on models to quantify risk, said Mr. Arnott.

“Risk is an adversary that's always going to be looking for areas that you haven't sought to protect yourself,” said Mr. Arnott. The fact that investors have added one slab of armor after another to address past weaknesses doesn't mean there aren't chinks in the armor — it only “hampers your ability to move,” he said.

Meanwhile, there's clearly more awareness of, and sensitivity to risk, but one downside of that could be amplified volatility, as institutional investors become more risk averse and consequently more skittish, he said.

Andrew Ang, the Ann F. Kaplan Professor of Business at Columbia Business School, New York, and chair of the finance and economics division, chose — in the spirit of David Letterman — to address the question of the lessons from the global financial crisis as a “top 10” list: